Cost allocation requires the following steps:

$1.$ Define the cost objects. The organization must decide what departments, products, or processes to cost$.$ In the example above, intranet users may be defined as cost objects. The cost object is often a subunit or department of the organization, such as a cost or profit center. Costs are often allocated to departments to better evaluate the departments$$ performance and to assess profitability. Or costs are allocated as a control device. This means that costs are shared to$,$ perhaps, limit the use of an expensive common cost, or to better spread the more expensive common cost more equitably.

$2.$ Accumulate the common costs to be assigned to the cost objects. Suppose IT costs are to be assigned to the departments. This step requires the identification and accumulation of the common costs such as the cost of the hardware, person$-$ nel expenditures, utilities, and software costs that will be distributed to the users.

$3.$ Choose a method for allocating common costs accumulated in step $2$ to the cost objects defined in step $1.$ An allocation base is the basis of how a company allocates its overhead costs. An allocation base is a quantifiable unit, such as machine hours used, kilowatt$-$hours consumed, or square footage occupied. The allocation base to distribute IT center costs to users can be time used, computer memory, or some combination of these. Common costs usually are allocated to cost objects using an allocation base that approximates how the cost objects consume the common resources.

For example, to provide network services for its employees a firm incurs expenses of $$575,000$ per year consisting of a computer lease $($$$273,000),$ labor $($$$195,000),$ software $($$$78,000),$ and other costs $($$$29,000).$ Four departments use various amounts of disk space for network usage measured in gigabytes $($billion characters$).$ Illustration $1$ shows disk space usage for the four departments.

Gigabytes of storage are used as the allocation base to distribute the annual e$-$mail cost of $$575,000$ to the departments. The allocation rate is $$2,875$ per gigabyte per year $($$$575,000-$: $200).$ Illustration $2$ displays the resulting allocated costs to each user department.

Illustration $1$ Network Users of Disk Space

$($in Gigabytes of Memory$)$

Users Gigabytes Used

Manufacturing $40$

Sales $80$

R&D $20$

Admin $60$

Total $200$

Illustration $2$ Allocation of Annual Network Cost to User Departments

Users Cost per Gigabytes Gigabyte of Memory Allocated Cost

Manufacturing $2,875\mathrm{.}0040115,000\mathrm{.}00$

Sales $2,875\mathrm{.}0080230,000\mathrm{.}00$

R&D $2,875\mathrm{.}002057,500\mathrm{.}00$

Admin $2,875\mathrm{.}0060172,500\mathrm{.}00$

Total $200575,000\mathrm{.}00$

Most firms allocate a good portion of corporate overhead back to their profit centers. The most common allocated costs include research and development, IT$,$ marketing and advertising, distribution expense, income taxes, and finance and accounting costs.

The following examples show the prevalence of cost allocations in profit and nonprofit organizations and another role of cost allocations: cost$-$based reimbursement.

$1.$ Manufacturing Organizations

Cost allocations are very common in manufacturing. Manufacturers cannot deduct all their manufacturing costs for financial reporting and tax purposes. Instead they have to track the direct manufacturing costs and allocate their indirect manufacturing costs among the units sold and the units still in inventory. Therefore, to calculate cost of goods sold, net income, and inventories, GAAP and income tax reporting need to include allocated indirect manufacturing costs.

Cost allocations also occur if a company has a cost$-$ based reimbursable contract, which is a contract pricing method where allowable and reasonable costs incurred by a contractor operating under are reimbursed as outlined in the terms of the contract. In this case, the company$$s revenues depend on reported costs, including allocated costs. For example, certain government defense contracts are cost$-$ based. The contract outlines which costs will be reimbursed, so the contractor needs to ensure that all costs are allocated in accordance with the terms of the contract in order to recoup these costs. Suppose an aircraft company manufactures both military and commercial aircraft. Military aircraft are produced under a cost$-$based contract. Subject to the contracts terms, the firm has an incentive to find the allocation basis that spreads some of the president$$s salary to the military aircraft production.

$2.$ Hospitals

Hospitals rely on reimbursement by the government $($Medicare and Medicaid$)$ and by private medical insurance companies. At one time in the United States, these payments depended on the costs reported by the hospital. In some states, nursing home reimbursement under Medicaid is still based on reported costs. Under cost$-$based reimbursements, cost allocation becomes an important factor in determining revenue. For exampl